Shadow Accounting Steps into the Spotlight

Investors have put pressure on hedge funds to ensure that accounting reports from independent administrators have been validated, writes Ron Kashden of Ingenious Initiatives.

In early 2013, when Bridgewater announced it would perform a full shadow of its primary administrator, Bank of NY Mellon, the industry took notice. The move put shadow accounting in the spotlight for fund administrators and back office teams. The industry will pay close attention to see how this initiative plays out and where the bar will be set from a due-diligence standpoint as we head into 2014. While there are many benefits to shadow accounting, such as a higher level of transparency and accountability, there are other forces that drive this trend.

Ron Kashden, Ingenious Initiatives

Growing interest from investors

Investors are putting pressure on hedge funds to ensure that accounting reports from independent administrators have third-party validation of their oversight strategies and processes. An Ernst & Young Global Hedge Fund and Investor survey found in 2012 that nine in 10 investors believe that shadow accounting is “highly beneficial to accurate valuation and reporting.” And as more funds contemplate which operations to validate in-house and mull over using an alternate third party administrator to double check, a consensus seems to be forming. All involved, from investor to service provider, agree that the added accuracy and the enhancements in the quality of the reporting that a shadowing environment allows are worth investing in. These environments satisfy the investor need, and also bring peace of mind to hedge funds by minimizing their risk of reporting incorrect data on investor statements and losing customers.

Regulatory requirements piling up

Additional regulatory reporting requirements can be a nightmare for any sized firm, but especially for small- to mid-sized funds that are still running back offices using Microsoft Excel. The volume of data mining necessary to keep up with strict reporting deadlines renders Excel obsolete, requiring funds to either outsource more middle and back-office processes, or develop the internal infrastructure to create robust databases and flexible reporting capabilities that aren’t afforded by Excel. Requirements for regulations like the Alternative Investment Fund Management Directive (AIFMD), the Foreign Account Tax Compliance Act (FATCA), and new CFTC filings such as Form CPO – PQR and CTA – PR are continually evolving. The funds need to stay on top of the latest developments to ensure accurate reporting. Penalties for noncompliance range from bad to worse, such as: withholding requirements for FATCA, revoking of access to European investors for AIFMD, or even a complete ban from acting as a CPO under CFTC. Shadowing eases these burdens through a more comprehensive validation to ensure reports meet the necessary requirements.

Opportunities for administrators

For fund administrators, shadow accounting is positioned to be a game changer. In light of the investor demands and regulatory requirements that push the movement forward, an effective shadow accounting operation built on the use of technology to manage the workflow can drive and support this trend. Not only are fund administrators already offering shadowing services to increase revenue, but bringing efficiency and transparency to reports will strengthen the customer bond. Sophisticated middle and back-office platforms built with the right technology and workflow tools that are optimized for current regulatory requirements can uncover numerous errors when cross-checking information. It also gives administrators the ability to review and sign off electronically, effectively replacing the need for outdated email communications and programs like Excel.

To meet investor demands and reduce the risk of noncompliance with the growing list of regulatory requirements, shadow accounting offers a level of transparency and value that makes everyone a winner. The popularity of shadow accounting over recent years represents a key turning point for the industry to bring a higher level of credibility and restore confidence.

—Ron Kashden is the founder of Ingenious Initiatives where he leads the company’s technology operations. With twenty years’ experience in financial services technology and accounting, he previously served as CFO of the Tiedemann Investment group and headed software development at SAC Capital and HedgeWare. He is a CPA and holds a B.S. in accounting from Lehigh University.